Rising U.S. Rates
The Federal Reserve is raising interest rates to combat stubbornly high domestic inflation. The federal funds rate, a key tool for monetary policymakers, could climb to 5% by early 2023, a sharp increase from the near-zero level they were held between April 2020 and February 2022. Higher interest rates slow inflation by privileging saving and discouraging spending.
Globally, rising interest rates in the U.S. contribute to a flow of currency towards the U.S. dollar. As investors exchange foreign currency for the dollar, foreign currencies depreciate and the dollar strengthens. This has ramifications for international trade and debt repayment, yet the effects are not felt equally between countries. The confidence which investors have in a country’s currency and the country’s debt level, among other factors, impact how countries are impacted and how they respond.
The strength of a country’s currency impacts its terms of trade with the rest of the world. When the Federal Reserve raises interest rates, the U.S. dollar, the currency in which the vast majority of international trade is done, strengthens, and the price of imports rises. While this impedes domestic investment and lowers living standards, a weakened currency boosts export sectors, as their goods are discounted on international markets. The theoretical respite to exporters is often annulled by a slow-down in global demand for imported goods.
A weakened currency also impacts debt repayment. For debt denominated in U.S. dollars, common in emerging markets, local currency depreciation increases the real cost of repayment. For example, a country might take out a loan in dollars (and assume the obligation of paying back in dollars) when their local currency, €1, buys $1. After a local currency depreciation, €1 may only buy $0.50, and the country will need more local currency to acquire the necessary dollars to repay their loan.
In countries where debt is issued in local currency, which is more common in developed countries, local central banks typically raise interest rates to combat their currency’s depreciation. This combats depreciation-induced rise to the cost of repayment by strengthening the currency, but this also increases the cost of new borrowing and makes future servicing of debt more expensive.
Developed countries have more resilient currencies that can withstand deflationary pressure. This is largely due to their central bank’s ability to raise interest rates and the confidence that investors have in the country’s currency. While this lessens the impact on a country’s terms of trade and debt repayments, higher domestic interest rates carry their own ramifications.
The European Central Bank (ECB), the central bank for Eurozone member states, is raising interest rates, partially out of fear of “falling behind the curve” of rising rates. The euro fell to dollar parity, or a 1:1 exchange rate with the dollar, in August 2022 for the first time in 20 years. Traders flock to where the real rate of return—the nominal return minus the rate of inflation—is highest, and the ECB is using their control of interest rates to fight the Eurozone’s unfavorable spread.
The extensive knock-on effects of interest-rate changes affect every part of a country’s economy. Countries with high debt-levels, like Spain and Italy, worry that higher rates will raise borrowing cost and make debt servicing more expensive. Others, such as Germany, contend that inflation is an untenable obstacle to business performance, and higher rates are a necessary policy response. The ECB’s predicament highlights a challenge every central bank faces: interest-rate decisions impact actors—in this case countries, not just sectors—in an economy differently.
Emerging market countries face a more daunting landscape than developed countries when responding to rising U.S. interest rates. Typically, their debt is denominated in dollars, not their local currency, and their central banks lack the tools enjoyed by developed countries to limit capital outflows and currency depreciation. This strengthens the threat of rising interest rates in the U.S. and forces their central banks to take strong action.
Countries in Latin America and Asia often carry high debt levels and suffer amidst high U.S interest rates. In Argentina, where over half the country’s considerable debt is denominated in dollars, the Central Bank of Argentina (CBA) has doubled interest rates to 70% over the past year to protect the Argentine Peso. Despite this, the Peso has lost nearly half its value, partially motivating a $44 billion dollar IMF capital injection.
Certain sectors are particularly vulnerable to a weakened currency. Real estate developers often earn revenue in local currencies but take out debt in dollars; an increased spread between the two brings financial pain. In Indonesia, two-thirds of the debt held by property developers is denominated in U.S. dollars, yet their revenue streams are exclusively in rupiah, the local currency. As the dollar strengthens against the rupiah, the threat of debt default increases.
Export-oriented sectors benefit from a weakened currency—their goods are cheaper abroad—and foreign investors, knowing that their dollars can go further, may be inclined to conduct foreign direct investment (FDI). The uncertainty around higher global interest rates and a depreciating local currency can annul these positives. Wealthy economies may pull back on imports amidst uncertainty and foreign investors will be similarly hesitant to invest abroad when the local currency is in flux.
The complex fallout from American interest-rate policy inspires responses from Western lenders. Institutions like the International Monetary Fund (IMF) help countries navigate monetary uncertainty, and major lenders attempt debt restructuring through groups like the Paris Club. The United States has discussed dollar swap lines—a mechanism to transfer U.S. dollars to foreign countries—to help cushion the flow of trading away from their currencies.
China’s recent emergence as a major lender complicates these efforts. China is the world’s largest bilateral lender, and the contracts of their loans are often kept secret. Researchers believe that a common feature of the contracts are “no Paris Club” clauses, provisions which elevate the importance of Chinese lenders’ repayment and pardon China from collective debt restructuring. This provides a major challenge to Western lenders: forgive loans and risk the money flowing directly to China, or do not forgive them and risk debt defaults.
The Chinese-debt-forgiveness dilemma is one additional wrinkle in a sprawling list of knock-on effects facing U.S. monetary policy decision-makers. The Federal Reserve balances its dual mandate with these byproducts, and nowhere is that balance more precarious, or as critical, as the ramifications of U.S. monetary policy abroad.